How Living Wills Can Work for ‘Too Big To Fail’ Firms

Outgoing FDIC Chairman Martin Gruenberg is calling for the continuation of the work the federal agency has done to better prepare the banking system for the next financial crisis, as President Trump’s pro-bank nominee to replace him goes through confirmation. Gruenberg, who was on the FDIC’s board during the Great Recession of 2008 before becoming chairman, had been warning against a movement to weaken post-crisis regulations so much so as to endanger the global banking system again.

Speaking recently at Wharton, Gruenberg in particular focused on the work the FDIC has done to comply with the “living wills” authority it received from the Dodd-Frank Act in 2010 — post-crisis laws designed to strengthen the banking system that Trump wants, but so far has failed, to repeal. Dodd-Frank has given the FDIC, working jointly with the Federal Reserve, the power to place large failing financial institutions into a receivership process for liquidation, and also require systemically important U.S. banks and other designated financial entities to each prepare a plan to allow for their orderly failure.

During the crisis, regulators faced the challenge of how to let a systemically important financial institution fail without causing a disastrous ripple effect throughout the system. Untangling a major banking conglomerate is not an easy task. These are complex entities, with operations in many countries that could be running hundreds of subsidiaries while at the same time having significant ties with other large banks. In the U.S., the FDIC was the banking regulator that had experience with bank failures.

But before Dodd-Frank, the FDIC did not have the authority to manage the failure of a systemically important global financial institution, Gruenberg said. So there were only two options available to regulators when Wall Street’s big banks started to wobble — a bailout by the government or bankruptcy. The latter was the choice regulators made for Lehman Brothers, and it deepened the crisis. “We needed a better option,” he said.

Living Wills Mandate

Dodd-Frank’s living wills requirement — much like a person’s living will that sets out terms for medical care at the end of life — forces big financial entities to think through their own demise and come up with changes to enable an orderly dissolution of their business, should the time arise. Since 2012, eight systemically important U.S. banks had been through this process — Citigroup, JPMorgan Chase, Bank of America, Goldman Sachs, Wells Fargo, Bank of New York Mellon, Morgan Stanley and State Street.

The living will plans must include the following information: the financial institution’s strategy for an orderly resolution in bankruptcy during financial distress; the range of actions they propose to take during the resolution, as well as their liquidity and capital needs and resources; description of their organizational structure, material entities, interconnections and interdependencies; and the corporate governance process.

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Gruenberg said these are not just ideas on paper to be shelved. “It’s not just a plan they have prepared. It’s a set of tangible changes to the structure and operations of these firms designed explicitly to facilitate orderly failure,” he said. Indeed, banks have been making the shifts at a “substantial cost,” Gruenberg added. The changes are “pretty fundamental in nature — to simplify organizational structures, pre-position the resources in terms of capital and liquidity, to establish backups, to support the critical services and resolutions. These are tangible operational issues.”

“It’s not just a plan they have prepared. It’s a set of tangible changes to the structure and operations of these firms designed explicitly to facilitate orderly failure.”

For example, some banks have worked to separate different brokerage or investment management activities while others have merged other units that perform similar functions to reduce duplication and simplify the organization, Gruenberg said. Other companies set up wholly owned subsidiaries to house key operations under one entity. Some have eliminated guarantees to foreign operations that could have posed risks to U.S. entities.

FDIC’s New Powers

Established by the Banking Act of 1933, the FDIC insures bank and thrift customer deposits to prevent bank runs that had led to thousands of bank failures during the Great Depression. Today, it supervises around 4,000 state-chartered banks and savings and loan institutions not part of the Federal Reserve System. It is also the backup federal supervisor of the remaining banks and thrifts. When a bank fails, the FDIC handles the resolution in bankruptcy usually by selling its deposits and loans to another bank.

Since the FDIC has experience managing bank failures, after the financial crisis, regulators around the world looked to it for guidance. “It was the only institution that had had really very favorable experiences in resolving banks — but they were not the complex financial institutions we have to worry about these days,” said Richard Herring, Wharton professor of finance as well as international banking who is a member of the FDIC’s Systemic Resolution Advisory Committee.

Indeed, Dodd-Frank gave the FDIC “an extraordinary and powerful new authority” to place into receivership financial institutions with at least $50 billion in assets as well as key non-bank entities, and force them to plan for the orderly winding down of operations, Gruenberg said. Along with the Federal Reserve, he said, the FDIC is turning those powers into a “meaningful tool to bring about fundamental change in the structure and operations of these firms to facilitate their orderly failure.”

Central to the FDIC’s new authority is to ensure that these big bank failures do not result in a taxpayer bailout, unlike in the 2008 crisis. Also, shareholders, creditors and top management will be held accountable for the failed financial institution. “This has been a top priority for the FDIC,” Gruenberg said.

And it puts the FDIC onto new terrain. “Orderly resolution of systemic firms had never been an explicit goal of financial regulation in the United States prior to the recent crisis,” Gruenberg said. “In fact, it was never really contemplated. The experience of the crisis and the enactment of the Dodd-Frank changed that.”

“Options and tools now exist … to help ensure that a systemic firm can fail, that shareholders, creditors and management of the firm bear the consequences of their decisions, and that financial stability can be preserved … without taxpayer bailouts.”

Global regulators, in particular, were concerned about handling financial institutions deemed “too big to fail,” Herring added. A bank seen as too big to fail distorts the market, Gruenberg said. That’s because other companies that deal with these banks, such as creditors, can give them advantageous terms to do business because they believe the government will not let these firms go under. This gives banks more confidence to place riskier bets — enhancing the dangers they pose to the financial system.

The FDIC’s new powers should help curb risky behavior. While it’s too soon to say whether living wills planning will work, “it is also true that we are in a different place today than we were in 2008,” Gruenberg said. “Options and tools now exist that provide a path far better than existed in 2008 to help ensure that a systemic firm can fail, that shareholders, creditors and management of the firm bear the consequences of their decisions, and that financial stability can be preserved during times of stress without taxpayer bailouts. It is critical that this important work continue.”

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